Will sliding dollar lead to plaza pact-ii?

Could the sliding dollar result in a new “Plaza” accord? If the greenback crosses $1.50 (Rs59.55) to the euro, the pips will really squeak in Europe.

It won’t be just Nicolas Sarkozy, the French President, who is calling on the European Central Bank to cut interest rates. Asian currencies, by contrast, haven’t risen much and remain hyper-competitive.

Political pressure will mount for a managed exchange rate system that pushes the yen and the renminbi up against both the dollar and the euro.

The dollar has been weak since 2002, primarily against the euro rather than Asian currencies. While the euro has risen 49% against the dollar, the yen and the renminbi have risen by less than 10%. The Canadian dollar and the pound have also risen sharply. Lower US interest rates, a continuing $700 billion annual payments deficit and a decline in long-term funds inflows have caused the dollar’s drop to accelerate. At $1.41, the euro is already 35% overvalued against the dollar based on purchasing power parity. Any further fall would intensify the cost disparity between the US and Europe.

That’s not true in Asia. The yen is around purchasing power parity against the dollar—and therefore sharply undervalued against the euro. The renminbi remains undervalued against practically every other currency, strengthening only 10% since 2005. Of Asia’s major currencies, only the South Korean won has been substantially strong against the dollar. At some point, European exporters will find the US market closing, while Japanese and Chinese exporters become increasingly ferocious competitors in the EU market.

Since neither Japan nor China believes in freely floating exchange rates, an exchange rate coordination agreement appears natural. The 1985 Plaza Accord committed the world’s leading economies to intervene to drive down the dollar. A “Plaza II” accord would intervene to drive up the value of Asian currencies against their major trading partners. This would require heavy political pressure on unwilling Asians, but open access to US and EU markets may be sufficiently important to them to make it achievable.